How investment and dilution works in startups

The first time I received investment I was totally lost and pretty scared. There was a huge sum of money at stake, and I didn’t have a clue what I was doing. The final documents from the investors totalled more than 150 pages of what seemed to me like indecipherably dense legalese.

I spent quite a number of late nights reading investment books, and trying to figure out this strange new world. Over time I began to realise that there were actually a few simple “first” principles that explained the world. Once I learnt to keep applying these first principles, the additional complex terms and long documents were much easier to grasp.

This post is about those simple first principles of investment. It explains the fundamentals of how shares, company valuations and investment are connected.

Real-world investment transactions can get pretty complicated, with huge amounts of details and complex terms. However, if you keep these basics in mind, you’ll have a pretty good basis for cutting through the complexity.

The basics of shares

Owning a share in a company means you own a portion of that company. For example if a company has one hundred shares in total, and you own ten of them, then you own 10% of that company.

There are many types of shares, giving the owner different rights. For example: some shares let you vote on company matters, some are non-voting, some shares have preferred financial privileges, some have ordinary privileges. For starters we’ll be focusing on the simple case where all of the shares in a company are ordinary voting shares, let’s call it basic shareholding.

In a basic shareholding situation if you own 10 shares in “Awesome Company” with 100 shares in total, then you have a 10% vote and the right to 10% of all company income and own 10% of the company’s assets. If the company is ever sold, you’ll get 10% of the purchase price.

Valuing companies and shares

The value of a share is determined by the value of a company. If Awesome Company is worth R1000, then each share in the company is worth:

The value of a company is generally determined by whatever someone is prepared to pay for it. There is no “fixed” value for a company. The only “true” value is what someone will pay for it. Similar to how a buyer sets the price for a company or share, an investor can set the value of a company by saying at what value they’d be prepared to invest. So when a company says they’ve raised at a “R20m” valuation, it just means at least one investor agreed that that’s the value of the company.

People don’t often buy an entire company. It is more common to buy and sell a portion of a company (in the form of a number of shares) than a whole company. In instances where individual shares are traded, like on the stock market, people generally use share transactions to determine the value of the company. The logic works as follows: if someone buys one share of a company for R10, and there are 100 shares, then we can say that the whole company is worth R1000.

So for Apple, at the time of writing, the share price was $98, meaning the last purchase of Apple shares was at a price of $98 per share. There are 5.477 billion Apple shares in total. So Apple Inc is worth $98 * 5.477 billion = $537 billion.

How investment works

Investment in a company means giving the company money in exchange for shares. The mechanics of investment aren’t always totally obvious, so we’ll start with explaining the basics.

The parties in an investment

People often think about investment as involving two parties, the investor giving money, and the shareholders being diluted. That seems logical, but that perspective can make it seem like the investor is giving the shareholders money, or that the shareholders are giving the investors shares. Both of these conclusions are actually incorrect.

To make it easier to understand investment, it helps to think about investment as also involving a third party, the company being invested in. The three parties are then:

The investor - giving money and getting shares from the company

The shareholders - who are being diluted

The company - getting money and issuing shares to the investor

The company receives the investor’s money, and gives shares to the investor. The existing shareholders approve the deal, but don’t actually receive money or give up shares (they do get diluted though, which is explained below).

Mechanics of an investment

Using our example Awesome Company (100 shares in total, of which you own 10 shares), we can illustrate this process. The shareholders of Awesome Company find an investor who is prepared to invest R500 in Awesome Company.

The investor and the shareholders agree that the company is currently worth R1000 (i.e. each share is worth R10). This is generally called the pre-money valuation - sometimes VCs shorten it to just “pre”. The investor is going to invest R500, which means the investor should get:

The investor is investing the money in the company, and the company issues an additional 50 shares. That means 50 new shares are created in the company and given to the investor, in exchange for the R500 investment. The R500 belongs to the company, increasing its value.

The total value of the company is now R1500. This is generally called the post-money valuation. It’s simply the value of the company (before the investment) plus the money invested.

Dilution

Dilution refers to the decrease in shareholding as new investors come on board. The shares of the existing shareholders don’t change, neither does the value of these shares. You still have 10 shares, valued at R10 each, for a total value of R100. What has however changed is your percentage holding of the company.

There are now 150 shares in total, so your percentage holding has changed.

Example Investment Deal

Venture Capitalists (VCs) will often summarise an investment deal by saying something like “I’m investing R5m at a R20m pre”. This means that they value the company at R20m before investment, and are investing R5m for a total post-money valuation of R25m. They will therefore expect to own 5/25 = 20% of the company after investment.

Note: It’s a common mistake to think the company is spending R5m to buy shares from the existing shareholders. With this view the investor would own 5/20 = 25% of the company, which is incorrect.

If you owned 10% of the company before investment, dilution will mean you’ll own:

Applying these principles to real-world situations##

Real investment deals tend to seem pretty far removed from our basic examples. VCs tend to add a lot of complex things like liquidation preferences, pre-money ESOP pools, convertible notes etc. In my experience however, a solid grasp of the basic principles of shareholding (plus Google) are enough to figure out the implications of these complex terms.

The basics I like to remember are:

A company’s value is simply the value of each share multiplied by the number of shares

Company valuation is ultimately determined by what someone is willing to pay, but is generally calculated from the value of individual share transactions.

It helps to think about investment as being a transaction between an investor and a company (as opposed to its shareholders)

Dilution (by investment) reduces the percentage of a company you own, but typically doesn’t change the number or value of your shares

On more than one occasion I’ve seen experienced financial guys, exhausted from deal stress and many late nights, make mistakes on these basics. If you can keep the basics in mind, and use Google (and your lawyer) for the complex stuff, you can get very far.